Do Nonprofessional Investors React to Fraud Red Flags?

Abstract:     
Investor losses from fraud have become a significant concern for policymakers. We experimentally examine whether experienced, nonprofessional investors react to fraud red flags. Prior research has shown that fraud firms exhibit multiple red flags in their 10-Ks prior to the detection of fraud. However, these red flags are not typically transparent to investors in the current financial reporting environment. We find that a transparent presentation of differences in key financial measures and nonfinancial measures (NFMs) that indicates multiple red flags leads to lower investment positions than a presentation of these red flags that is not transparent. This finding is important as it suggests that when multiple fraud red flags are present but not transparent, investors continue to invest in firms where losses from fraud are more likely. Additionally, we find that when only a single red flag is present (i.e., lower fraud risk), a transparent presentation does not affect investment levels.

Number of Pages in PDF File: 49

Keywords: accruals, fraud, investor, nonfinancial measures, red flag

JEL Classification: M40, M41

working papers series